April 20, 2017

A Whole New Level of Risk

In the quest for generating higher returns on debt funds, some fund houses have been pushing the limits of prudent and acceptable credit risk.  For most, it has been in the extent of their exposure to low-grade securities.  For some, such as Taurus MF and the erstwhile JPMorgan MF, it has also involved adding concentration risk to the mix.  As I noted in an older post, at one time, the top 2 holdings of the erstwhile JPMI Short Term Income Fund accounted for 34% of the portfolio (with Amtek Auto alone accounting for 18%).  More recently, Taurus Ultra Short Term Bond Fund and Taurus Short Term Income Fund each had, at one point, over 20% of their portfolio in CPs of BILT and its subsidiary, BGPPL.  But the endeavours of these fund houses pale in comparison with the risks taken by a certain other fund house in managing one of its debt funds.  For the purpose of this post, I will refer to this fund as ‘Rainbow Fund’.

To me, the fund house behind this fund has never inspired enough confidence to examine its schemes, let alone invest in them.  Rainbow Fund was brought to my attention a couple of days ago, thanks to a friend who is also a long-time industry observer.  Apparently, it had been the subject of some talk because of the fact that despite significant exposure to lowly-rated securities, it was highly rated by Value Research (VR).  Since I am familiar with the VR rating methodology, I don’t see this as a contradiction.  If anything, I am amused by the fact that according to VR, Rainbow Fund carries “below average risk”.  But when my friend mentioned that its portfolio yield was as high as 11% pa, that piqued my curiosity and I decided to take a closer look. 

It turned out that a month ago, the yield was 11.61% pa while a year ago it was 12.46% pa.  Of course, such yields are a reflection of the exposure to low-grade securities.  Sure enough, I saw that as per the latest disclosure, 43% of Rainbow Fund’s portfolio was in securities rated A+ or lower.  But then there was an additional 25% in unrated securities.  And as scary as those numbers are, here’s what really stunned me: as per the disclosure, all the unrated securities were zero coupon bonds that were scheduled to mature between Jan 2019 and Nov 2021.  As far as I could make out, most of them did not have any put option and those that did, were only in 2019 or later.

In case the importance of that eludes you, it means that over and above the risks of investing 43% of the portfolio in lowly-rated securities, by investing in unrated zero coupon securities the fund house had risked not just its principal but the entire interest that it stood to earn as well.  By my estimate, if any of these securities were to default, the impact on an investor would be around one and a half times of what it would have been in the event of a default of a regular return security of similar yield.  But what is most alarming to me is that an investor can simply get out of the fund before any of these securities mature and in the process, pass the entire risk on to the remaining investors. That has the potential to create chaos.  While the fund has put in stiff exit loads as a deterrent, their usefulness is a matter of debate. As I see it, all it would take is a certain number of investors to exit for the remaining investors to realize the pointlessness of staying in the fund.

Some years ago, a wise man shared with me his thoughts about those who take risks.  “There are those who play with fire,” he said, “And then there are some who dance with fire.”  Looking at the portfolio of Rainbow Fund, this fund house seems to be doing a tango.

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